A liquidity ratio that measures a company’s ability to pay off short-term liabilities with highly liquid assets
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What is Cash Ratio?
The cash ratio, sometimes referred to as the cash asset ratio, is a liquidity metric that indicates a company’s capacity to pay off short-term debt obligations with its cash and cash equivalents. Compared to other liquidity ratios such as thecurrent ratioand quick ratio, the cash ratio is a stricter, more conservative measure because only cash and cash equivalents – a company’s most liquid assets – are used in the calculation.
Formula
The formula for calculating the cash ratio is as follows:
Where:
- Cash includes legal tender (coins and currency) and demand deposits (checks, checking account, bank drafts, etc.).
- Cash equivalents are assets that can be converted into cash quickly. Cash equivalents are readily convertible and subject to insignificant risk. Examples include savings accounts, T-bills, and money market instruments.
- Current liabilities are obligations due within one year. Examples include short-term debt, accounts payable, and accrued liabilities.
Example
Company A’s balance sheet lists the following items:
- Cash: $10,000
- Cash equivalents: $20,000
- Accounts receivable: $5,000
- Inventory: $30,000
- Property & equipment: $50,000
- Accounts payable: $12,000
- Short-term debt: $10,000
- Long-term debt: $20,000
The ratio for Company A would be calculated as follows:
The figure above indicates that Company A possesses enough cash and cash equivalents to pay off 136% of its current liabilities. Company A is highly liquid and can easily fund its debt.
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Interpretation of the Cash Ratio
The cash ratio indicates to creditors, analysts, and investors the percentage of a company’s current liabilities that cash and cash equivalents will cover. A ratio above 1 means that a company will be able to pay off its current liabilities with cash and cash equivalents, and have funds left over.
Creditors prefer a high cash ratio, as it indicates that a company can easily pay off its debt. Although there is no ideal figure, a ratio of not lower than 0.5 to 1 is usually preferred. The cash ratio figure provides the most conservative insight into a company’s liquidity since only cash and cash equivalents are taken into consideration.
It is important to realize that the cash ratio does not necessarily provide a good financial analysis of a company because businesses do not ordinarily keep cash and cash equivalents in the same amount as current liabilities. In fact, they are usually making poor use of their assets if they hold large amounts of cash on their balance sheet. When cash sits on the balance sheet, it is not generating a return. Therefore, excess cash is often re-invested for shareholders to realize higher returns.
Key Takeaways
- The cash ratio is a liquidity ratio that measures a company’s ability to pay off short-term liabilities with highly liquid assets.
- Compared to the current ratio and the quick ratio, it is a more conservative measure of a company’s liquidity position.
- There is no ideal figure, but a ratio of at least 0.5 to 1 is usually preferred.
- The cash ratio may not provide a good overall analysis of a company, as it is unrealistic for companies to hold large amounts of cash.
Related Readings
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